Offbeat Offerings: Exchange-Traded Notes

by Cara Scatizzi

Exchange-traded notes (ETN) are newcomers to the investment world. Although the name and acronym bears a resemblance to exchange-traded funds (ETFs), and they trade on an exchange (as do ETFs), they are quite a different investment vehicle. They are much more complicated to understand, they have different tax implicationsand they carry a lot of risk.

First and foremost, ETNs dont actually own any assets. Instead, they are promises made by the issuer to pay, at a specified maturity date, an amount that mimics the returns of specific market indexes. For that reason, ETNs have the credit risk of the issuing bank, along with the market risk of the asset class to which they are tied.

Typically ETNs cover sectors of the market that are difficult for investors to enter directly. Barclays was the first to introduce these securities in 2006 with the goal of making the commodities and currencies markets more accessible to individuals.

How It Works

Unlike ETFs, ETNs dont own anything. An ETF has a value based on the portfolio of assets it holds. An ETN, however, is basically a bet on the change in value of an index. The ETN is purchased at a price (either at issue or on the secondary market) that reflects the current value of an index, with the issuer promising to pay the full value of the index at maturity, minus management fees.

For that reason, a big concern for investors should be the financial shape of the firm issuing the ETN. If this firm goes bankrupt and is unable to pay off its promise (something that recently does not seem so unlikely), the ETN holder gets nothing. There is no guarantee of receiving any payment for this investment.

Because ETNs are exchange traded, prices are affected by fluctuations in the value of the underlying index. The value of an ETN is also affected by the credit rating of the issuer. This means that the ETN value may drop due to a downgrade in the issuers credit rating, even if there has been no change in the underlying index value.

Investors can hold ETNs until maturity or sell in the open market before maturity. If held until maturity, the issuer gives the investor a cash payment in the amount that typically reflects the value of the tracking index or exchange rate minus investor fees. A currency ETN tracks an exchange rate and makes payment based on the change in the dollars value over the holding period.

An example: The iPath S&P GSCI Total Return Index ETN (ticker GSP) tracks the S&P Goldman Sachs Commodity Index, a composite index that covers a diversified group of commodity sector returns. Its maturity date is 6/12/2036. If held until maturity, investors will receive a payment that mimics the indexs total return for the holding period, minus any fees.

If an investor wants to sell early, he will receive what other investors think it is worth in the open market.

One advantage of ETNs that is touted by ETN issuers is that they have less tracking error than ETFs. Tracking error refers to the difference between the value of an ETF or ETN and the actual index value that it seeks to track or to which it is tied. Fund expenses reduce the returns of both ETNs and ETFs, and are one cause of tracking errors. However, tracking errors can occur with an ETF if its basket of securities does not fully match the index it is seeking to track. Since ETN issuers promise to pay the full value of the index or commodity being tracked (less expenses), ETNs have no tracking error other than the difference due to fund expenses. However, ETNs tend to have higher expenses than ETFs, which somewhat offsets this tracking error advantage.

Types

Most ETNs track commodities like oil, gold, natural gas, coffee and sugar, or currencies (exchange rates between the U.S. dollar and U.K. pound or Australian or Canadian dollars). There are a handful of providers of ETNs.

Barclays offers 28 iPath ETNs which range from energy, coffee and crude oil to a number of exchange rate ETNs and one that follows an emerging markets strategy.

Bear Stearns offers one ETN that tracks an index measuring the composite performance of midstream energy-oriented master limited partnerships. The future of this ETN is uncertain given the unknown fate of Bear Stearnsan example of how these types of risky investments can fail.

Goldman Sachs also has one ETN that tracks a version of the S&P GSCI index. Elements ETN, a consortium, provides 22 ETNs in three categories: currency, equity and commodity.

Deutsche Bank offers 19 commodity-based ETNs. They are offered in a variety of types including double short, double long, and short. The double option essentially doubles down on the index performance, either short or long. Investing in a double long ETN would mean at maturity an investor gets twice the index gain or loss. Short ETNs are for investors who think the value of the underlying index will fall.

As with many investments, there are numerous provisions that can be added to these securities, including call options. Be sure to read the prospectus for an ETN before investing to fully understand all of the facets of the investment.

How to Trade

ETNs are bought and sold through brokers and are traded on the American and New York stock exchanges.

Investor Suitability

As with most non-traditional investments, ETNs can offer a way to diversify holdings and give investors access to commodities and currency markets. However, these are complex and risky securities with many facets and should be properly researched and fully understood before any money is committed.

Tax Consequences

Current tax rules dictate that investors treat ETNs as prepaid contracts, which means that the difference between the purchase price of the ETN and the price at which it is sold should be treated as a capital gain. Because there are no dividend distributions, taxes are paid only after the ETN has matured or is sold in the secondary market. ETN issuers advertise this as a tax advantage over ETFs because the ETNs final payout is a total return that does include reinvested dividends. Thus, the investor receives a total return that includes dividends but does not have to pay taxes on those dividends until the shares are sold (rather than annually as with mutual funds and ETFs).

However, the IRS has not yet finalized a ruling on ETN taxes, and has not ruled favorably for investors on these kinds of issues in the past.

Before you invest in any of these products, make sure you understand the latest tax rules, and be aware that the IRS could change the rules of the game at any time.

The Pros

More Easily Tap Into Currency andCommodities Markets
Investors who want to enter the currency or commodity markets can use ETNs as a way to gain exposure to these markets.

Tax Advantages
Although an investor receives a total return that includes reinvested dividends, typically there are no dividend distributions paid throughout the holding period, so under current tax law no taxes are due on an ETN holding until an investor sells shares.

The Cons

Issuer Credit Risk
ETNs are not backed by any asset, but rather only a promise of a pay-off by the issuer. If the issuer is unable to make the final pay-off due to its own financial deterioration, an investor may receive substantially less than promised or may lose the entire investment.

Value Affected by Issuer Credit Ratings
An ETNs value is not only affected by the value of the tracking index, but also by the issuers credit rating. If that rating is downgraded, the value of the security might fall even though the underlying index value might not have fallen.

Market Sector Risk
Because ETNs focus on one sector or commodity, they are undiversified and can be highly affected by issues that move only certain sectors.

Higher Fees Than ETFs
ETNs tend to have higher expenses and fees than a typical ETF to compensate for the smaller tracking error.

Complex Investment Product
The structure of these products is more complicated than other investment vehicles such as mutual funds and exchange-traded funds, and thus they are more difficult for individual investors to understand and evaluate. In addition, the sectors of the market that they typically focus on are typically more risky and less familiar to individual investors than the more traditional asset classes.

Offbeat OfferingsOffbeat Offerings: Exchange-Traded NotesAn investor reference for products that are not your typical offerings. This issue's focus is on exchange-traded notes--a new, but risky, structured product that provides an alternative way to invest in the commodities and currency markets.

Portfolio StrategiesThe Core Approach to Building an Effective ETF PortfolioAs investment products increase in number and complexity, many individuals are searching for an approach that keeps it simple and low-cost. Exchange-traded funds (ETFs) offer a useful starting point, and using the core index portfolio approach, you can build effective portfolios ranging from the basic to the complex--all at a low cost.

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